Fraud, Folly or Probability

As the government continues to pump money into AIG, the foundering insurance giant which found itself at the center of the real estate and financial crashes, I’ve seen increasing numbers of commentators demand to know why no one is calling for the jailing of AIG executives on charges of fraud. How, the argument goes, was their selling of financial insurance products any different from the sort of fraud Maddoff carried out? They sold insurance policies they couldn’t cover! They took money and gave nothing in return!

I think this tends to underline that people don’t actually understand insurance and how it works very well. This is doubly concerning in that insurance has become increasingly central to people’s ideas of economic security in the last few decades. Indeed, we’ve reached a point where lacking health insurance is itself considered a health problem, regardless of whether this actually results in someone failing to receive needed treatement.

What is insurance? Basically, insurance is a way of extending your savings for unlikely but high cost eventualities.

For example, if I were to die this year, it would place a very heavy burden (in the form of lost earnings) on my family, such that it would be very difficult for me to save enough money to be prepared for the possibility. However, for a few hundred dollars a year, I can buy life insurance that would, if I should die in the next ten years, pay out a lump sum equivalent to 5-10 years of my current earnings.

The insurance company can afford to offer this to me because they believe they have an accurate model of how likely a healthy 30-year-old man is to die before 40. However, if a horrific plague were to strike the US, killing 10% of the population, and I was among its victems, could I console myself on my deathbed with the knowledge the insurance company would be taking care of my family?

No. Their models do not account for the possibility that 10% of the healthy, adult population would die in a single year. They would undoubtedly go bankrupt and my family would get little or nothing.

This is something we don’t normally think of in regards to insurance, because insurance companies have good enough models that it would take something very unexpected to make them unable to meet their obligations. Still, because insurance companies base their prices on what they believe to be the probability of having to pay out, if something unforseen by their models occurs, they may well find themselves on the rocks. One should always understand insurance to come with a “all other things being equal” sort of proviso.

But shouldn’t AIG have been able to forecast the possibility of a global real estate downturn and take that into account in their pricing? To my knowledge, there’s never been a real estate downturn of the scale of the current one on such a wide scale. Sure, plenty of people were predicting the housing market would go down. That was one of my own reasons for getting out of California back in 2003 — but those who bought a house there when I left would have seen 50% appreciation over the next four years before things went south. And even though many people were going around saying, “It has to go down,” there was no historical precident for such a widespread downturn. In the past, it looked like so long as the economy and population were growing, real estate would continue going up.

Now, if you’d asked me in 2006 to insure mortgages against real estate values going down (and the resulting mortgage defaults), I would have refused. And some cautious companies doubtless did. But since there was a decent historical/statistical case to be made that they wouldn’t go down, it’s not exactly a surprise that someone agreed to meet the need.

Shouldn’t there have been regulations in place to prevent people from offering insurance products that they wouldn’t actually be able to pay out on in an emergency? Well, here we run into the probability problem again. Is it in fact likely that something will occur which will bankrupt an insurance firm? There’s no reason to believe that regulators will be all that much better at understanding what could happen in the future than insurance actuaries are.

In the end, we probably just need to accept that sometimes bad and unexpected things happen. We can do our best to prevent them, but the funny thing about unexpected events is that it’s hard to know they’ll happen until they do.

So no, I don’t think there was necessarily fraud involved here. Though there was an excessive faith in our ability to forecast the future. We’d do well to avoid such excessive faith in analytics in the future, and yet most of the suggestions for “fixing the problem” simply involve having government regulatores forecast the future instead of private insurance writers. I rather doubt that ends us up in a better place.

10 Responses to Fraud, Folly or Probability

I think where the fraud comes in is when billions of government dollars are pumped into private businesses. The opportunity for corruption on an epic scale between politicians and business men and women is probably unparalleled in our nation’s history. In short, I think the fraud is probably underway now.

Yes. Justly, AIG should have been declared insolvent and its assets sold off to it’s more cautious competitors who were more careful in their choices. Keeping them afloat helps avoid some (potentially very bad) short term pain, but sends a bad moral hazard message in the long term.

Insurance isn’t what made AIG insolvent. Derivatives made AIG insolvent. Derivatives can be like insurance, but are not insurance. One of the differences is that bankruptcy doesn’t provide shelter from derivatives.

Why AIG was bailed out was more akin to the following. Say your brother offers your mother an investment and gives assurances of its soundness. Your mother gives him 20% of her savings, not alturistically but because she believes the investment is sound and good for her. Your brother manages to lose 80% of your money. Certainly you can tell your mother that she needs to take responsibility. You can tell her that she needs to forgive her son and your brother. You may even offer a pittance to help her get by. This is what is happening at a more global scale. If AIG were to go down, a number of very large European banks would go down with it. Much of the aid given to AIG has gone to those banks. Needless to say Europe isn’t much interested in hearing, “Oh that’s the free market, sorry.” They aren’t interested in having their economy tank because U.S. regulators couldn’t manage their banking system. The US isn’t exactly in a position to ruthlessly default. A signficant number of dollars in our stock exchange is held overseas. (The largest investors in Citibank are in the Middle East.) Recalcitrance on bailing out AIG would have resulted in a stock market crash. If I remember right, there were 1.5 TRILLION DOLLARS in sell orders ready to execute just prior to the announcement that the government was taking over AIG.

Insurance isn’t what made AIG insolvent. Derivatives made AIG insolvent. Derivatives can be like insurance, but are not insurance. One of the differences is that bankruptcy doesn’t provide shelter from derivatives.

Definitely, CDSs are not insurance, though the point that interested me was that their pricing depends on a probability of default, which is something which the issuer is responsible for forecasting. And they are effectively used as insurance, in some cases, by investors.

I guess I’m a little confused as to the point that bankruptcy would not provide shelter from the derivatives to AIG. You may well know more about this detail than I, but I know I’ve heard several economists write or say that the government should have let AIG go down, and I would assume that had they gone down they would have been unable to pay out on CDSs they had issued for any further companies that defaulted. So sheltered or not, the CDSs would have gone away if AIG broke.

Needless to say Europe isn’t much interested in hearing, “Oh that’s the free market, sorry.” They aren’t interested in having their economy tank because U.S. regulators couldn’t manage their banking system. The US isn’t exactly in a position to ruthlessly default.

I’m a bit confused by this. Your suggestion is essentially that the poor, simplistic European banks bought a number of investements which turned out, because people’s statistical forecasting models did not take into account extraordinary events, to be unsustainable, and that therefore it is now our duty to use government funds to make those investments good anyway (privatized gains and socialized losses across borders?) because the Europeans would otherwise be shocked and angered that we failed to regulate to keep their banks from buying investments that would pull them under?

If the problem is that American financial institutions are under-regulated compared to European ones, then shouldn’t the virtuously regulating Europeans refuse to get involved with American investments lest they be burned?

Really, though, this all comes back to the forecasting question, which was what actually interested me in this discussion. Rare but cataclysmic events are inherently very hard to forecast, and I really see no reason to believe that regulators would be any better at doing so than the financial products division of AIG. Government regulators’ decision biases would be different, but not necessarily in better ways, just different ways.

If AIG were to go down, a number of very large European banks would go down with it. Much of the aid given to AIG has gone to those banks.

This is certainly true, and in fact the value of this indirect bailout of European banks, in real dollars, is likely to exceed the amount given in the Marshall plan. What isn’t clear is why bailing out insolvent European banks should be the responsibility of the American government, rather than of governments in Europe.

The European banks bought mortgage securities and hedged by buying default swaps from AIG. Perhaps I should have introduced another brother into the scenario to better analogize the situation. The point of the analogy was not however a criticism of regulation but to note that the process is not atomized. Like the mother’s investment with her son, the son and mother have mutual interests that extend beyond the investment transaction. There was a reason Clinton was in China two weeks ago. The US economic life is not autonomous but a part of our foreign policy. We have troop commitments in Afghanistan and Iraq and myriad of lesser interests, not to mention maintaining our petrodollar status, that would be significantly effected if we just pretended that AIG’s issues were in a box seperate from US issues. The most significant issue is that no one else sees the seperate box.

As to Blackadder’s question, the Euros have already stuffed a lot of money into their banks. Britain has nationalized I think 3 of them now. In some respects the question is like asking the starving man why he doesn’t buy a bowl of soup.

If only Obama could articulate this to the American public then most of the confusion and ridicule would subside. President Obama doesn’t want to fall into the same pitfall of failing to explain his policies like President Bush did.

As to Blackadder’s question, the Euros have already stuffed a lot of money into their banks. Britain has nationalized I think 3 of them now. In some respects the question is like asking the starving man why he doesn’t buy a bowl of soup.

The UK has given large amounts in bailouts. The rest of Europe hasn’t. If the idea is that European governments are simply incapable of giving more, then this would seem to be rather damning for their financial system as compared to our own.

The linked article doesn’t carry as much water as you want it to carry. France, Germany, Belgium, and the Dutch has all participated in bailing out banks. Yes, the European banking system has many problems. Eastern Europe, Spain, and Ireland have real estate bubbles that may be worse than our own. Ditto Brittain. If we are however measuring which financial system can handle a default by AIG, the answer is apparently none, or at least we are afraid to find out.